FACTBOX-Policy challenges loom as Yellen prepares to lead Fed

January 06, 2014|Reuters

Jan 6 (Reuters) - Janet Yellen, who was confirmed by theU.S. Senate on Monday to succeed Ben Bernanke as chair of theFederal Reserve, will take the helm of the world's mostinfluential central bank as it attempts to finally move on froman era of economic crisis.

When Yellen, an accomplished economist and the Fed's currentvice chair, takes the reins on Feb. 1 she will face a series ofdelicate policy challenges, starting with how quickly to winddown the Fed's aggressive bond-buying campaign.

Here are the main challenges on the horizon:

BLOATED BALANCE SHEET

After three rounds of quantitative easing, or QE, the Fed'sbalance sheet has swelled to about $4 trillion, a record leveland far higher than the approximately $1 trillion the Fed hascarried in more normal times.

Some fear the money the Fed created to purchase this haul ofTreasuries and mortgage-backed securities with the aim ofencouraging investment, hiring and economic growth could stokeinflation in the years ahead, and potentially causehard-to-detect market disruptions and asset bubbles.

The Fed announced on Dec. 18 that it would modestly trim thepace of its monthly bond purchases to $75 billion in Januaryfrom $85 billion. But it remains keen to keep borrowing costslow by convincing investors that interest rates will not risefor a while longer.

The trick for Yellen will be winding down QE withoutrattling financial markets or disrupting an economic recoverythat has proven vulnerable to domestic and foreign shocks.

LIFTOFF FOR INTEREST RATES

The Fed's main policy tool, the overnight federal fundsrate, has been near zero since the darkest days of the financialcrisis in late 2008. The first increase is not likely to comeuntil 2015, based on Fed predictions, though that could changeif inflation or unemployment veer away from expectations.

The central bank had said it would keep rates where they areat least until unemployment dropped to 6.5 percent, as long asinflation did not threaten to top 2.5 percent.

But financial markets at times have questioned thecredibility of the Fed's policy promises. If investors start toexpect rates will rise earlier than the Fed intends, borrowingcosts could start to rise and trip up the economy.

Right now, everyone agrees that unemployment is too high andinflation too low, so the Fed has faced a relatively easydecision on keeping monetary policy very loose.

But inflation is running well below target. If it does notstart to pick up, policymakers will face the difficult questionof whether to ramp up their already extraordinary stimulus tostave off deflation.

On the other hand, if inflation perks up and threatens toreach the Fed's 2.5 percent upper threshold, policymakers mightbe forced to tighten policy despite higher-than-desiredjoblessness.

Possibly complicating things, the Fed will for the firsttime be able to also raise the interest rate it pays banks onthe excess reserves they hold at the central bank. Doing soshould stem what could otherwise be a flood of bank reservesinto the marketplace that could threaten to overheat the economy- but it is an untested tool.

LONGER-TERM EXIT STRATEGY

Further out on the horizon, the central bank will have toshrink its balance sheet to a more normal size, whether byletting the bonds it holds mature or selling them outright. Thequicker it reduces holdings, the tighter monetary policy willbecome and the greater the pressure on markets to absorb theassets.

But perhaps most sensitive for the Fed, selling bonds couldgive rise to losses that would lead to a temporary end to itsregular remittances to the U.S. Treasury, potentially openingthe door to action by politicians who want to rein in thecentral bank's prized independence.

(Reporting by Jonathan Spicer; Editing by Paul Simao and ChizuNomiyama)